The Fed's Real Objective in Keeping Rates Near Zero

One of the key objectives of the Federal Reserve in pursuing these policies has been to drive investors back into riskier asset classes. By lowering the fed funds rate below 0.25% and promising to maintain a near-zero policy rate for an ‘extended period,’ the yield on near-cash instruments has all but evaporated. No surprise, then, that net outflows from money market mutual funds have exceeded a $50 billion clip in recent months.

Furthermore, by adding $262 billion to Treasury holdings, $79 billion to agency holdings and $515 billion to mortgage-backed security holdings from March through mid-October, the Fed has also suppressed the yields available to households in these segments of the fixed-income market. In effect, we believe the policy gambit has been to herd investors into equities and corporate bonds by reducing yield opportunities in other asset classes. By doing so, we believe the Fed has sought to induce wealth effects designed to cushion the blow of the past year’s financial crisis on real economic activity.

Thus we face some incompatible truths. Demographically [think baby boomers], more investors should be migrating to lower-risk portfolios and looking for asset mixes that provide some combination of high-income yield, security of principal and inflation protection… Policy-wise, central banks have responded to the economic carnage wrought by a major financial crisis by lowering short-term interest rates, which reduces yields on near-cash instruments like money market funds and Treasury bills. Through quantitative easing measures, they have been bidding down yields in a variety of longer-term fixed-income classes, like government bonds, mortgage-backed securities and, in some cases (as with the Bank of Japan), even corporate bonds.

Investors who demographically are at a stage of life when they need to earn high yields with fairly secure principal while maintaining a good hedge against inflation risks are finding central banks have clipped the menu of many opportunities. We suspect this portfolio incompatibility may not end well.